Net Present Value (NPV) Net present value measures each project's contribution to shareholder wealth.

While there are several long-term investment decision criteria, the net present value method is favored because it tends to focus on building shareholder value and has the fewest limiting assumptions. Decision under this method may be taken in the following few steps: i. Forecast the future project cash flows, noting when the flow occurs. ii. Estimate the opportunity cost of capital. The opportunity cost of capital is the expected rate of return given up by investing in the project under review.
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iii. Calculate the present value of the future cash flows discounted at the opportunity cost of capital rate. The present value of the cash flows represents the maximum amount that investors would pay for the investment. iv. Compare the present value sum of the future cash flows with the investment outlay The net present value is the excess of present value sum of the future cash flows over the investment outlay is the net present value. If the net present value is positive (greater than zero), make the investment. If the net present value is negative, forgo the investment. v. Rank all positive-NPV investment projects in order of their NPVs. The project with maximum positive-NPV would be considered most attractive. Actual investment may be undertaken in the order in which projects are ranked. NPV = At / (1+K)t - C where At is the series of cash inflows over time periods 1..t; K is the cost of capital; C is the cost of the project. The expected net present value of a project is the added shareholders' wealth provided by the project. Additional net present values generated by investments are represented in higher stock prices. The net present value method is a proxy for financial market investor analysis of business investments. Projects that are expected to generate negative net present values will reduce shareholders' wealth by the expected negative NPV. It is worth mentioning here that the process described here assumes efficient markets, where there is close correspondence between changes in fundamental or intrinsic value of the firm and the market value of the firm as reflected in stock prices. Internal Rate of Return (IRR) An alternative to the NPV method is the internal rate of return (IRR), which is the discount rate that, having discounted the expected cash flows, will produce a present value equal to the cost of the project. In other words, IRR is a discount rate that will generate an NPV of zero. According to the IRR method, one may invest in any project offering a rate of return higher than the opportunity cost of capital. R is the internal rate of return when At / (1+R)t = C The IRR of a single future cash flow (PV) or an annuity flow (PV of annuity)

may be determined easily and arithmetically as the discount rate that equates the cost of the project with the present value of the future cash flows. The IRR of a multiple, uneven cash flow stream involves more than one unknown and is not easily solved arithmetically.
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One must iterate, often several times, selecting an expected IRR and discounting the cash flows until the NPV of the project is zero. This method produces results that are similar in some ways to that under the NPV method. The internal rate of return, or IRR, or the discounted cash flow (DCF) rate of return, is the discount rate at which NPV equals zero. If the rate of return is greater than the opportunity cost of capital, the NPV of the project is greater than zero. If the NPV of a project is less than zero (negative) the rate of return is less than the opportunity cost of capital. Thus, the rate of return rule and the NPV rule are equivalent. The IRR must not be confused with the opportunity cost of capital. The IRR is the rate of return expected from the cash flows of the investment. The opportunity cost of capital is the minimum return acceptable to the firm and the minimum acceptable rate of return demanded by investors in financial markets on similar risk investments. While the IRR is easier to understand than the NPV, the NPV should be used as a final decision criterion for an investment, since IRR has a number of theoretical pitfalls. i. Where the finance manager faces several mutually exclusive projects, one must be selected and the others deferred or passed by. Here the IRR may give a conflicting choice relative to the NPV, which focuses more accurately on shareholder value. Only analysis of the IRR on incremental basis will give decisions consistent with the NPV. ii. In case of mutually exclusive projects involving different outlays but same lives, small projects may be erroneously selected over larger projects using the IRR. iii. Any change in sign (+,-) in periodic cash flows produces as many IRRs as there are changes in the cash flow directions of the investment. Many investments, such as oil or gas wells, entail added outlays after several periods of positive cash flows, producing the arithmetical possibility of multiple IRRs.